Oracles, Soothsayers and Fortune Tellers

By Jim Puplava         Jan 11 2003 www.financialsense.com

Life is never predictable. To us mortals, it is full of surprises and twists and is constantly changing. As human beings, we are resistant to change preferring the status quo. Because of all of the ambiguities and enigmas of ordinary life, humans have always sought reassurance and guidance in handling the problems of living. Some find solace in spiritual guidance provided by the Bible, the Koran, or the holy books of Eastern religions. Prior to the age of the great religions, oracles, soothsayers, and fortune tellers provided this guidance.

Oracles were prophets who received their visions directly from the gods. The oracles gave their responses to inquiries and their answers were considered divinely inspired. Oracles were usually associated with a sacred temple, shrine or public religious institution. The oracles were especially gifted in the art of interpreting symbols understood as messages from the gods. These symbols required the special expertise of a trained expert in the interpretation of phenomena of a very unpredictable or even trivial nature. In the Greco-Roman era, the more common types of divination included the casting of lots, the flight pattern and behavior of birds, the examination of the entrails of sacrificial animals, various omens, and the interpretation of dreams.

The cost of consultation with an oracle was expensive and usually only the wealthy or the heads of state could afford their services. Historical records from the ancient Greek world during the 5^th and 4^th centuries BC indicate the minimum charge for services of the Oracle at Delphi were the equivalent of two days wages for the average Athenian. Besides the base charge, individuals seeking advice from oracles would be required to pay additional sums in the form of freewill offerings as well as traveling expenses.

For the state, the oracle’s charges were as much as ten times the rate for private citizens. However, no king or military commander would make a major move to go to war or initiate battle without a favorable word from the oracle. For lesser folk concerned with the outcome of this year's harvest or the marriage of a daughter, there was less expensive advice that could be had from the local village soothsayer or fortune teller. Like the king who sought a favorable omen before going into battle, ordinary individuals sought reassurance from the everyday uncertainties of life. The oracles, soothsayers, and fortune tellers made life certain through predictability.

Human nature has not changed since the ancient days of the Greeks and Romans. We still face uncertainties on a day-to-day basis whether it is in everyday living or the financial markets. Just as ancient farmers sought reassurance for the year's harvest, investors seek reassurance for this year's markets. The markets prefer certainty and so do individual investors. It would be far better for the markets and investors if trends never changed. Firmly established trends are much easier to predict and act upon than trends that are in a constant state of flux. However, financial trends never remain permanent. They are in a state of constant flux. Booms turn into busts and bull markets are followed by bear markets, which make for unpredictability in the financial markets. Markets abhor uncertainty, preferring a straight path in which to follow. However, the essence of a living organism is movement. The same is true for the financial markets.

To remove this uncertainty in the financial markets, investors have turned to financial forecasts to provide them with reassurance in a world that is unpredictable. To get this reassurance, they have turned to the modern world’s version of oracles, soothsayers, and fortune tellers. The highest oracle in the land is Alan Greenspan, the modern day equivalent of the Oracle of Delphi. After the Chairman of the Federal Reserve, there are lesser oracles who are mainly Wall Street economists and analysts. Then we get to the soothsayers and fortune tellers. This disparate group is made up of various personalities ranging from cable TV anchors, local financial talk show hosts, journalists and authors, to newsletter writers.

As I said in last year's January Storm Watch Update, 

In an effort to bring certainty to our world and our financial markets, we rely on forecasts. We have weather forecasts, election year forecasts, financial forecasts, and even sports forecasts. The purpose of these forecasts is to lend a sense of assurance in a world that is unpredictable. It has been that way throughout human history. From emperors and kings to prime ministers and presidents, leaders and their followers have relied on forecasts to guide them in their decision-making. In the old days, we called them oracles, soothsayers, prophets, and seers. Today we have come to know them as weatherman, pollsters, economists, and analysts. Their job is to predict the future when the future itself is unknowable. They take uncertainty and by their forecasts make that uncertainty certain. (1)

And What Does This Year Portend?

The problem for the oracles and soothsayers this year is that the world and the financial markets have become more unpredictable. We have been in a recession and the current state of the economy is very delicate. For the first time in nearly half a century, the world economies are experiencing a synchronized slowdown and recession. The financial markets have witnessed three back-to-back years of double-digit losses, something we haven’t seen since the years of the Great Depression and early 70’s. The world is also more unstable today because of threats of terror and war. Rogue states are acquiring weapons of mass destruction, terrorist groups are multiplying, genocide is on the rise, and religious and revolutionary wars are breaking out around the globe. The era of peace and stability is over. We live in uncertain times.

The forecaster’s role will be difficult this year as it is compounded by geopolitical and economic problems. This has made forecasts more unreliable, raising questions over the forecaster’s credibility. In response to inquiries, they haven’t been able to read the entrails of economic data correctly. Their forecasts have been wrong for three consecutive years. Perhaps they haven’t heard correctly from the gods? The second-half recovery in 2000 was postponed to 2001. Perhaps the correct interpretation was 2002 or will it be 2003 or 2004?

Their problem is that the world and the financial markets haven’t been following the script laid down at the beginning of the year. Instead of recovery, we got a recession. (The Bureau of Economic Research has yet to call off the recession.) Instead of rising corporate profits, we dealt with fictional earnings and scandals. In response, the markets didn’t go up. They went down. Their forecasts of certainty have now been replaced with doubts, skepticism or ambivalence.

So here we are again at that same time of the year when our dear oracles and soothsayers and market seers look deep into their crystal balls. We mere mortals wait with eager anticipation. Hopefully the oracles have read the various economic entrails and omens correctly and the years of famine are over. This year’s forecasts look like more of the same. The message is that the famine is over and this year’s financial harvest will produce a bumper crop for investors.

One of the hazards of soothsaying is being bold and straying from the pack. Going with the offbeat and the unexpected is more memorable with the throngs of investors. If you’re right, your stature as an oracle is enhanced. If you're wrong, you can lose your job or your subscribers. If you're wrong, it is better to be wrong as a group -- that way nobody looks bad. Predicting the obvious is one way to remain safe. So, go with the obvious. It makes you look credible and keeps people coming back for more. If GDP grew at a 3% rate, then stick with the same trend and forecast a 3.2% rate. Hope has to be kept alive; otherwise people stop listening. So the message must be upbeat like “Better Times Lie Ahead.”

FORECAST 2003

Listed in the table below is this year's forecast. It looks like more of the same. For the fourth straight year, our modern day oracles and soothsayers are predicting a second-half recovery. The general message is that strategists expect stocks to be up this year, ranging from high single-digits to low double-digits. The advice is to expect a solid single instead of a home run. However, after three years of striking out, a single looks good. In the annual BusinessWeek Economic Survey, economists expect real GDP growth of about 3.2% -- about the same as last year. Corporate operating profits (That's pro forma profits as nobody uses net income figures anymore.) are expected to grow by close to 10%. The inflation rate is projected to be moderate at 2.2%, ten-year Treasury yields will rise to 4.8%, and the unemployment rate is expected to fall. Experts believe the Fed has achieved price stability, so it has room to inflate. Meanwhile, the Fed is worried about deflation.

The Business Week Economic Survey, "What the Seers See for 2003"

The Business Week Market Survey, "2003: The View from the Street"

The Wall Street Journal Forecasting Survey for 2003
in percent except for dollar vs. yen and dollar vs. euro

The Wall Street Journal's forecast for the 2003 remains the same: economic growth will pick up later in the year. In other words, they too suggest another second-half recovery. The Journal's forecast doesn’t predict as high a rise in interest rates as BusinessWeek and they don’t see the unemployment rate dropping. However, the consensus remains pretty much the same. There isn’t much difference between the two. Both forecasts expect economic growth to remain the same, corporate profits to improve, inflation to remain moderate and the stock market to rise. The major markets aren’t expected to surpass old bull market records, but the general trend in the major indexes will be up this year.

What is surprising about this year's forecast is the high state of bullishness of the forecasters. In contrast to the muted state of optimism of a year ago, the strategists and portfolio managers in the BusinessWeek survey exhibit an elevated enthusiasm towards this year's market prospects. The basis for this optimism is the damage done to the markets over the last three years. They "foresee" that because stocks have fallen three years in a row, it is highly unlikely that stocks will go down this year. That only happened once in 1929-32 during the Great Depression.

During the holidays, I read copies of almost every major business and financial publication I could get my hands on. The headlines looked the same, characterized by a general high state of bullishness. Bloomberg Personal Finance went with stocks, bonds, real estate and the 21 best mutual funds for the year. Smart Money went with “Six Sectors Ready to Rally” and had a caveat article “Is the Bear Market Over? “ The advice was traditional with 12 stock recommendations and two fixed income investments. Money Magazine featured a picture of Michael Dell. The headlines were “10 Top Stocks and Funds, Today’s Best Bond Buy, and The Real Estate Guru." Regarding last year's forecast, there were a few mea culpas. Kiplinger’s Personal Finance featured articles on how to “Be a Better Stock Picker, Winning Small Stocks, and Best Online and Full Service Brokers.” Forbes went with "Build Your Own Business, 17 Stocks for 2003 and How to Be a Landlord.” Fortune featured “10 Stocks to Buy Now, 15 Safe Dividend Plays and 5 Smart Ways to Hedge Your Bets.”

Local, national, and financial newspapers were even more bullish. Headlines included “Wave Goodbye to the Bears” in the Financial Times, “Confidence Is Growing That Economic Pickup Is Real Deal This Time” in Investors Business Daily; while The Denver Post featured a headline that read ”Investors Want to Be In Stocks for Next Year. Returns Will Be Double Digit.” A Merrill Lynch survey of global money managers found that 74% of these managers are looking for gains this year. That's down from 85% the year before. In the BusinessWeek survey mentioned above, 95% of the analysts believe the S&P 500 will be up this year. That's up from last year's survey when less then 90% of the analysts believed the S&P would go up. Even more surprising is the fact that investors pulled out less than $20 billion from their stock mutual funds last year. The majority of Americans are still holding on to their stocks despite horrific losses over the last three years.

This is not the way bear markets end when the vast majority of investors are still fully invested and money managers are decisively bullish. Investors might have been outraged by the accounting scandals of last year, but that didn’t lead to any follow up behavior in selling off stock or mutual fund holdings.

Despite three horrific years of losses, most investors remain bullish. Denial may be a more appropriate word since a distinguishing feature of last year's downturn is the new trend to become an ostrich by refusing to look at or open investment statements. What we have just gone through has been no ordinary bear market. This fact has yet to register with investors. One of the most aggressive monetary policies in the history of this nation has failed to stem the tide of falling stock prices or prevent a recession from occurring.

THREE ECONOMIC DRIVERS TO RECOVERY

Why the bullish forecast and why are forecasters more optimistic this year? There are many reasons why forecasters, analysts, economists or any other name you want to call our present batch of seers are so sanguine this year. The list of reasons varies, but includes an expansionary monetary and fiscal policy, an increase in capital spending by business, and a resilient consumer. Forecasters now believe that business and government spending can pick up some of the slack lost by a possible retrenchment by consumers. The consumer is still expected to shoulder the heavy burden by accounting for close to 70% of GDP. However, business and government will be lending a hand.

DRIVER # 1 GOVERNMENT FISCAL AND MONETARY POLICY

Most economists and forecasters believe the most important engine for the economy could be the federal government. The majority of economists believe that fiscal stimulus would be the most import driver in the economy this year. Monetary policy has been impotent in preventing a recession or stopping the stock market from hemorrhaging. So fiscal policy is expected to pick up the slack. The President has proposed a $670 billion stimulus package made up of accelerated income tax cuts from his 2001 tax bill, new tax breaks for writing off business equipment, the elimination of the double taxation of dividends, extended unemployment benefits, the elimination of death taxes, and money to aid unemployed workers in their efforts to find a job. Democrats have proposed their own version of a stimulus package, which includes more unemployment benefits, one-time tax rebates of $300 and a few other spending programs. Their stimulus package is estimated to cost around $136 billion.

Both parties are eyeing next year’s presidential and congressional elections. The President is very cognizant of what happened to his father’s reelection bid with his economy emerging out of a recession. His father won the Gulf War, but lost voters' trust on the economy. A weak economy would favor the Democrats; while a strong economy and financial market would favor the President's party.

There will be a tough battle over the budget along party lines. The President is unlikely to get much help from the other side as they would like to recapture the White House and along with it, both houses of Congress. The President is going to need enormous political skills to get want he wants from Congress especially with an election year around the corner. Wall Street is hoping for a big stimulus package, but Washington is more attuned to political infighting. It is going to take enormous political capital and skill to get his package through Congress whose chief focus will be next year’s election.

Even if the President gets most of what he wants, the President is fighting an uphill battle. Keynesian fiscal stimulus may give the economy a temporary reprieve, but the US economy is still saddled with all of the excesses and malinvestments from the 1990s credit bubble and stock market mania. The credit bubble has gotten even larger as the Fed has fought the recession and deflation with the most expansive monetary policy in this nation’s history. M3 Money Supply, as shown in the graph below, grew at an annual rate of over 16% during Q4 of last year. Recently, it has been growing at a rate of $20 billion a week which annualizes to $1 trillion a year. The budget deficit which has grown as a result of a weakened economy and increased government spending is now approaching 3% of GDP. The current account deficit is now averaging over $125 billion a quarter. We are borrowing over $500 billion a year from foreigners, which represents the bulk of the world’s savings. Even if the consumer continues to spend, that money is being spent on foreign goods which does little to benefit domestic producers.

It is apparent from the graphs shown above that the US economic and financial system is headed towards a major train wreck. It is only a question of timing. Nobody in Washington or Wall Street sees it, for they are all either Keynesian or Monetarist or a combination of both. Even the bastion of the bond markets, Pimco, is calling for Keynesian-style stimulus and monetary reflation. Wall Street wants the government and the Fed to use all means at their disposal to ward off a deflationary debt collapse.

Therefore, if the government has to run deficits into eternity and spend wildly, then so be it. If the Fed has to expand credit, monetize assets, intervene in the financial markets by propping up stock prices or peg interest rates, then get on with it. Wall Street has a big stake in keeping its version of financial capitalism alive. The world of structured finance is in danger of imploding and the danger of this implosion has been deemed unacceptable in financial and political circles.

The danger here lies with inflation, instability, volatility, and ultimately, the collapse of the world’s present monetary system -- something the world has not seen since the days of John Law. It is apparent that there will be no foot put on the breaks as credit will be supplied in ample quantities to help levitate financial assets of all types whether it is asset backed securities, equities, real estate or any other credit market instrument.

It is now taking nearly $2.5 trillion of new credit a year to keep the American economy and financial markets functioning. The debt is rising at levels never seen before in history -- reminiscent of a biblical flood. That this insanity goes unquestioned, and in fact is encouraged, is even more surprising. The world of structured finance is vulnerable to a ten-sigma event. One can only speculate what this event will be -- a topic that will be covered in my next Storm Watch Update “Ten-Sigma” which has been delayed because of the holidays.

DRIVER # 2 CAPITAL SPENDING

Like last year, forecasters are predicting that capital spending will improve and help cushion the slowdown expected in consumer spending. Economists are anticipating that business spending will lead this year’s second half recovery. Operating profits are expected to grow by 10% as businesses slash expenses and improve profitability and productivity. That improved productivity has come from slashing payrolls. Most businesses have postponed capital spending for the last two years. In fact, it may be argued that American business has postponed capital spending for the last two decades. At one time rising investment in tangible assets such as plants, equipment and other forms of machinery was a necessary ingredient for a healthy economy. Investing in new factories created demand, boosted employment and income, improved productivity and helped to create general prosperity.

Balance Sheets and Goodwill

Austrian economists believe that investment is the only component within GDP that simultaneously increases demand and supply. However, throughout the 1980s and the 1990s, capital spending began to lag general economic growth. Corporations sought to increase growth more through acquisitions and mergers. Companies began to take on more debt and issue more stock in an effort to grow sales and profits. Corporate balance sheets ballooned with debt.

From the beginning of the 80’s, corporate debt grew by 382%. From 1996-2001, it grew by more than 50%. (2) Tangible assets on corporate balance sheets have fallen from close to 80% to today’s 53%. Tangible assets such as plant and factories have been replaced by intangible goodwill. This is one reason why I believe Wall Street and the financial media never talk about net income anymore. Net income has been ravaged by the greatest writedown of corporate balance sheets in history. Much of this worthless goodwill has been capitalized because of corporate acquisitions. Goodwill is the difference between what a company pays to acquire a company and the actual net worth of the company acquired. This difference is reported as goodwill on the balance sheet and is now in the process of being written off.

On the day I started writing this Storm Watch Update, AOL-Time Warner announced that it would take an additional writedown of $10 billion because the value of America Online had declined. The media company may have to writedown more of its $81.7 billion in goodwill. Last year they booked the largest corporate expense in corporate history when it took a $54.2 billion charge in April. As of the third quarter of last year, AOL had $36.3 billion in remaining goodwill.

Underfunded Pensions

This year, besides goodwill writedowns, companies will face another major profit killer in the form of pension contributions. A majority of the S&P 500 companies have underfunded pension plans. During the boom years when stock prices were rising, companies were able to count the surplus from appreciating pension portfolios as company profits. Many companies were able to avoid making pension contributions because of appreciating portfolios. A rising stock market replaced the need for company contributions to the pension plan. IBM stopped contributing to its pension plan in 1995. Even after the bull market ended, companies were still able to book pension plan profits even though the value of the company plan was declining due to deflating stock prices. This is due to a quirk in the accounting laws that allows companies to make certain assumptions regarding pension returns. Most company pension plans are still assuming returns of 8-10% annually, even though actual returns have been negative.

GM announced that profits would fall by 26% this year because the cost of its underfunded pension will triple to $3 billion after a slide in stock market investments. General Motors, whose $76 billion pension obligation is the biggest in the US, said it was lowering its expected growth rate on its pension assets from 10% to 9%. The lower expected return will result in lower earnings for the auto giant as its pension contributions triple this year. The company is expected to have pro forma profits of $5 a share in 2003 after excluding losses from its Hughes Electronics unit and certain other undisclosed expenses. The actual returns on GM’s pension assets were negative by 7% last year due to market losses. GM’s pension liabilities are greater than shareholder equity of $20.5 billion as of the end of 2001.(3) In one sense, you could say the company pensioners own the company.

The big story and profit killer this year is going to be underfunded pension plans. For the S&P 500 companies, who have defined benefit pension plans, estimated pension liabilities are close to $300 billion. This is the big risk this year. Unless the bear market in equities ends soon, this number is going to get even larger. For company CEOs, the year ahead is filled with many unknown risks -- a weak stock market is one of them.

Debt Service

The other profit killer is debt service. Companies have been able to refinance much of their debt over the past few years, but credit spreads have widened as a result of growing credit risks. Last year was another record year for bankruptcies. Half of the 10 largest corporate failures in history, as measured by assets, occurred last year. The list of failures included some of the top names in American business. The list included Kmart, Global Crossing, WorldCom, Adelphia Communications, Conseco, and UAL. Credit rating agencies expect more of the same this year. They predict that one in every 13 companies with non-investment grade debt will default this year. That is double the average of the last two decades. In the junk bond sector and especially in telecoms, one in five companies is expected to go under. In textiles and software, one out of every six companies is forecasted to go bust.(4) Analysts warn to look out for companies with debt payments coming due this year or companies that are burning through cash.

Therefore, while the oracles are forecasting a recovery in business spending, there is nothing on the horizon that suggests that business is ready to open up its wallet. In its latest outlook, the editors of BusinessWeek appear cautiously guarded. “A true recovery depends on the willingness of business and investors to take risks. Without it, investors won’t invest, financiers won’t finance, and businesses won’t make commitments to future growth in the form of new capital spending and new hires."(5) Instead of increasing spending after September 11^th, companies cut back on capital spending on plant and equipment by 5% and cut payrolls by 1.2 million. The editors' point to three telltale signs that capital spending is on the mend. They include growing orders for capital equipment, a narrowing of credit spreads between corporate and government bond yields, stock market prices, and bank lending.(6) Currently credit spreads are still rising as shown in the graph above.

However, the greatest inhibitor to renewed capital spending is profits. The profit performance for American companies has improved, but remains dismal. The big story of 2002 was that much of the highly touted profit miracles of the 90’s turned out to be a fraud. Those profits were more fiction than reality and were the result of creative accounting and off-balance sheet financing. You can’t have the micro elements growing faster then the macro aggregates. Yet, despite the fiction of the 90’s, Wall Street analysts keep dishing out double-digit profit forecasts. You can’t have the macro, in this case the economy growing at a 3% rate, and the micro aggregates corporate profits growing at rates as high as 20%.

At the start of last year, analysts had profits growing at double-digit rates by the end of the second quarter. By Q3 and Q4, profits were growing at 30 and 40%. These rates turned out to be preposterous. Even though the analysts were referring to pro forma numbers, those pro forma numbers only grew by single-digits.

The expectations are just as wild this year. It is a game designed to fleece investors. Profits are grossly inflated at the beginning of the year and are designed to lift expectations. As the year wears on, estimates are lowered dramatically, allowing companies to beat expectations. The real earnings are buried and the hype becomes the story.

This year, according to I/BE/S, the consensus for earnings is a rise of 13% in the US. It is important to note that Barron’s, which includes goodwill charges, reports 12-month trailing earnings for the S&P 500 are only $30.34. Wall Street analysts are estimating at this juncture in the year that S&P 500 earnings will range from $48-$54 for 2003. Based on the recent trailing earnings of around $30, that is a jump of anywhere from 58% to 78%. The only way you get these kind of earnings is to back out restructuring charges, goodwill impairment charges, stock option expense, and this year's profit killer -- pension costs.

Like so much of what is reported to the investment public these days, the real earnings are whitewashed, sanitized, and scrubbed clean of any defects. What is presented for public consumption are earnings that are on the mend. These forecasts of renewed earnings gains are only possible if measured against profit expectations that have been dramatically reduced. During the third quarter earnings game, estimates were lowered to such an extent that the real story became the fact that companies were handily beating expectations. However, non-financial earnings actually fell from $358.7 billion to $321 billion, a drop of 10%. The drop in profitability has improved. However, earnings have not been a barnburner. This is typical of profit recoveries coming out of a recession. Most recoveries see explosive earnings as the economy recovers, businesses pare back costs, sales and prices rise, and profit margins improve. We have yet to see this happen.

Most improvements in profits have come from cost cutting -- mainly payrolls. From a macro economic view, this cost cutting reduces economic activity. Laid off workers see their income reduced, which also reduces their ability to spend and consume. As the graph of long-term profit trends from above illustrates, profits as a whole have been on a downward slope since the mid 60’s and 70’s. Instead of business investment in new plant, property, and equipment, which increases both demand and supply, American businesses have chosen instead to build growth through acquisition and mergers.

In summary, without an improvement in real profits, it is unlikely that the US economy will see a capital-spending boom necessary to produce an enduring and prosperous recovery this year. This leads us to the third best hope for an economic rebound, the American consumer.

DRIVER #3  CONSUMER SPENDING

God bless the American consumer! The weight of the world’s economy seems to be resting on the backs of the American consumers and their propensity to borrow and spend. It is important to realize that consumer spending is directly related to what happens in the job market. Many economists are citing increased business investment as one of the key drivers in this year's economic rebound. However, businesses have been cutting payrolls in order to reduce expenses and increase profitability. Fired workers don’t make good consumers. A fired worker sees his or her income reduced, which also reduces their ability to borrow and spend. Already the buzzword for this year is that it will be a "jobless" recovery.

In order for businesses to hire workers, they would have to see profits increase, which would supply the fuel for spending more money on capital equipment. If American businesses were to see pricing power return, profit margins improve and cash flow increase, that might provide the fuel to embark on a capital-spending boom, which in turn might lead to the hiring of more workers. However, judging by what companies said at the end of Q3 and going forward, there doesn’t seem to be any evidence of that. Companies ranging from Intel, IBM, GM, Ford, and Cisco don’t see any improvement in business conditions. It is a very tough and competitive pricing environment out there. Manufacturers still face stiff pricing competition from foreign imports, especially China.

The macro outcome of cost cutting cannot lead to general prosperity. If one company cuts costs, it may benefit that particular company. When the entire industry cuts costs, it leads to reduced economic activity. When examining the economic and corporate press releases, you read very little about hiring new workers. The unemployment report for December surprised the markets on Friday with news of 101,000 job cuts last month instead of the expected 20,000 new jobs that were projected by economists. The unemployment report indicates more job layoffs and further cost cutting in still the force du jour. When you hear words coming from company CEOs like "downsizing" and "restructuring," that means more cost cutting and job layoffs lie ahead.

There are no signs of a pickup in hiring outside the federal government. This means that the job market will remain weak and dampen consumer desires to spend more money. That is why there is a mixed outlook from economists regarding consumer spending. The consumer, more than any other sector within the economy, is single-handedly responsible for rescuing the economy and pulling it along since September 11, 2001. By stepping up to buy new cars, new homes, entertainment systems, furniture and other consumer goods, the recession was brief and the economy recovered.

The lowest mortgage rates in half a century enabled the consumer to tap into the equity of their homes. A new bubble in mortgages led to additional bubbles in housing and consumption. By taking advantage of rising home prices, consumers have been able to extract equity out of their homes and direct that equity towards new consumption.

Last year it is estimated that consumers pulled $170 billion in equity out of their homes.(7) As of the third quarter of last year, mortgage debt was growing at an annual rate of $900 billion. According to Doug Noland of PrudentBear's Credit Bubble Bulletin, Q3 mortgage debt was 88% of non-finance credit growth, up from 63% in 2001, 49% in 2000 and 39% in 1997.(8)

In its effort to thwart a recession and fight a bear market in equities, the Fed created multiple bubbles in mortgages, real estate, and consumer spending to take its place. As these graphs below illustrate, the consumer has been able to leverage up by extracting more equity out of his home. Lower mortgage payments improved cash flow and the ability to spend and consume. One of our own employees informed me that he was able to reduce his monthly mortgage payment from $2,900 a month at the beginning of last year to $1,900 by the end of the year. That is an annual savings of $12,000.

 
 
Source: http://www.agaryshilling.com/ 

Therefore, this fragile recovery in many ways still rests on the ability of the American consumer to borrow more money at low interest rates. The job market is still weak with the trend towards higher unemployment, which means more layoffs and fewer consumers. This unhealthy trend will not last forever. Housing prices will not go up annually at double-digits or high single-digits forever. Debt levels for many consumers will eventually reach a limit. Debt burdens only look good when compared to rising housing prices or net worth. However, as the graph from A. Gary Shilling’s Insight shows, household net worth has been falling along with falling equity prices. What happens to the consumer when housing prices fall and interest rates rise? A drop in housing prices of as much as 10-40%, as usually occurs during a housing downturn, would wipe out the equity of most homeowners.

Debt Stretches Stress The Consumer

There is growing evidence that stress levels at the consumer base are starting to rise, although this isn’t given much publicity. Most consumers have maxed out their credit cards. Here in California the credit-counseling business is booming. As of October 2002, consumer credit stood at $1.72 trillion. Non-business bankruptcies rose by 401,306 in the third quarter of last year, up 13% from 349,981 in the same period the previous year.(9) According to Consumer Credit Counseling Services of Los Angeles, about one-third of their clients have credit card debt that is so high they will never be able to pay the debt off in their lifetime.(10)

Nobody is expecting a housing bust this year, but there is evidence that prices have begun to soften. They are already softening at the McMansion level. Housing still remains strong, but the rate of increase is starting to fall. How much longer can this pace continue? Even if rates remain steady, prices can’t keep going up forever. Why? Because they eventually rise to a level where they become unaffordable. Interest rates also have a limit as to how much they can fall and debt limits in the US have a limit. Last year US private sector borrowing at $2.4 trillion accounted for 60% of all debt raised globally.(11)

It appears that it is taking even larger doses of new credit to keep the American economy humming along. If it took $2.4 trillion last year, then how much more will it take this year? You can’t build prosperity on debt and consumption. But American policymakers seem to think so. To the detriment of the safety and soundness of our economy and financial system, there is an over emphasis on consumption. Over the last three decades, personal consumption has risen from around 60% of GDP in the 70’s to the present rate of around 70%.

What drives the American economy is debt and consumption. The American economy has been transformed from the first half of the 20^th century where it was dominated by savings, investment and manufacturing. By the end of the century, the US economy was dominated by debt, consumption, and service. If this tend continues and is not reversed, it will eventually lead to impoverishment and the end of American economic dominance. There are many signs that this process has already begun.

How long the present trend of more debt and consumption can continue is anyone’s guess. It is my own opinion that it will not last much longer. I would be surprised if it lasts beyond the next presidential election cycle.

MY FORECAST: EXPECT THE UNEXPECTED

As I mentioned at the beginning of this essay, forecasts generally tend to be linear in nature. Present trends are extrapolated forward without much change. Wall Street and Washington tend to ignore the dangers of debt. The huge malinvestments from the 90’s credit bubble are still with us. With the Fed hell bent on avoiding deflation from a credit collapse, they are pulling out all stops to expand credit and keep the financial system liquefied. The money supply was growing at an annual rate of 16% during the fourth quarter.

In addition to plenty of monetary stimulus coming from the Fed, there will be a greater emphasis on fiscal stimulus this year. The President has proposed a massive $670 billion stimulus package. At least most of the package is made up of tax cuts. Taxes reduce the economic burden of society. However, the President's plan also includes a healthy amount of government spending.

Consumption has become the Holy Grail in US economic and political circles. In fact, criticism of the President’s plan comes from the consumptionist crowd that believes the plan doesn’t emphasize enough consumption. Many of the critics of the tax cuts believe that cutting taxes for the “rich” is wasteful because rich people would only save and invest the tax savings. Cutting taxes on lower economic groups is believed to be more beneficial, because it would increase consumption.

Ignored in this argument is that the US will be running a budget deficit of close to $300 billion or more this year. Therefore, there will be plenty of Keynesian-style stimulus from increased military spending to prosecute the war on terrorism, to increased jobless benefits, to increased aid for unemployed workers to find jobs. The plan is pure Keynesian. Keynes recommended that governments decrease taxes, increase spending, and run deficits in order to revive the economy. The President's plan includes elements of both, with the emphasis on tax relief. However, today’s modern Keynesian prefers higher taxes and spending. There are too many tax benefits in the President’s plan for Keynesians to take comfort from it.

The Markets

So where does this leave us this year? The markets and the economy will not be linear as most forecasts would suggest. I expect that the stock and bond markets will gyrate in periodic spasms throughout the whole year. Volatility will be on the rise this year -- both in the stock market and in the bond market. These trading rallies will be induced by direct intervention in the financial markets supported by a tremendous marketing effort by Wall Street and the financial media. More of these rallies will take place in rapid succession in just a few days of breakout gaps as witnessed throughout the rallies of the second-half of last year. The Summer rally was made up of three four-day pushes, just as the late Fall rally and the new rally of this year. These rallies all seem to begin with a breakaway and runaway gap that are followed in quick succession. I called them “flag pole” rallies as shown in these three graphs of the first trading session of this year and the NASDAQ rally experienced on January 9^th.

The NASDAQ rally on January 9^th was attributed to a mistake made by a trader in adding an extra “0” to a buy order. The rally in the S&P 500 and the Dow was credited to a very “large” buyer in the futures market.

Massaging The Message

The one common characteristic of all of these rallies is that they originate in the futures pit. The rallies are always attributed to a particular large buyer who nobody knows and remains anonymous. Their common pattern has become easily recognizable. They resemble flagpoles as shown in the graphs above. The market goes straight up like a NASA space launch at the opening bell, usually during the first 15 minutes of trading. The major averages then linger there the rest of the day. The financial media then try to explain it in some inane way. Common explanations range from “better-than-expected” economic reports to better earnings results (even though the actual numbers were worse than the year, quarter, or month before).

Lately these rallies occur on days when the economic or financial news isn’t especially good. They also occur when key technical support levels are about to be broached for the major indexes.

Watching the War Drums

A likely scenario is that the markets head hard down during the first half of the year due to disappointing economic and financial news, war with Iraq and deadly terrorist attacks that are expected to follow. If the war goes quickly and is not followed by terrorist attacks here in the US, the US equity markets will go ballistic. A great uncertainty will have been removed from the financial markets. Oil prices would come down, which would act as an economic stimulus in itself. The President would have enormous political capital to get most of his stimulus package passed by Congress. The markets would act favorably in the short-term. However, the malinvestments from the 90’s credit boom haven’t even started. In fact, the malinvestments have gotten even worse due to the mortgage bubble triggering additional bubbles in real estate and consumption.

Watching The Debt Levels

There is also the enormous debt burden on consumers and corporations that still overhangs on the economy and the markets. Companies will need to rebuild their balance sheets. Consumers are now in the process of rebuilding savings as job prospects look grim and debt levels crimp the monthly budget. State and municipal budgets are also in a crisis mode especially in California and New York. In California, the governor has just proposed a massive $8.3 billion tax increase. States will be raising taxes this year, which will trim more money from consumers take-home pay. States are raising everything from income taxes, property taxes, sales taxes and sin taxes to raising fees on services. Higher state tax burdens will offset many of the gains coming from the President’s proposed tax cuts.

Because of rising debt issues, increased state taxes and a continued weak job market, I believe we will see the consumer retrench even more this year. If that happens, what remains on the horizon to act as a stimulus for the economy this year? The mortgage, real estate, and consumption bubbles literally rescued the economy after 9-11. What takes their place? It has to be either government fiscal spending or business capital investment. As discussed earlier, I don’t see capital spending improving until business profitability is restored, balance sheets repaired and pricing power returns to the business marketplace. I just don’t see that happening this year. If profitability improves, it will come only from cost cutting, which from a macro sense, reduces economic growth. Higher profitability and prosperity aren’t consistent with general cost cutting.

Therefore, I believe that there is a high probability that this year could become the first time since the Great Depression that the stock market experiences four back-to back years of consecutive losses. There are simply too many unknowns out there with geopolitical risks and increasing credit default risks at the government, corporate and consumer levels.

Lastly, let us not forget that stocks aren’t cheap. The Dow still sells at 3.6 times book, the S&P 500 trades 4.3 times book value and the NASDAQ has no earnings. Pro forma P/E ratios are 23 for the Dow and over 30 for the S&P 500. So unless you are smoking weed, popping hallucinogens or are on some other mind-altering drug, there is no way that trailing earnings are going to go from $30.57 on the S&P 500 to $48 or $54 this year. That is unless you strip out all impairment charges, stock option expense, pension plan contributions, plant writedowns and other restructuring charges and expenses that reduce earnings.

Watching For Those Wild Cards

Finally, there are all of those wild cards yet to be played this year. The financial system is as highly geared as the economy is leveraged. Debt imbalances exist everywhere in the system from leveraged money center banks to hedge funds. Looking at the derivative book of J.P. MorganChase, Citigroup, and Banc America, you might say they have become hedge funds. Besides these leveraged financial players, there is also the huge debt burdens of corporate America. Thanks to the devious lending practices of money center banks, corporations today now have more debt held offshore in limited partnerships than is shown on their balance sheets. Then there is the leveraged American consumer who continues to go deeper in debt in the ordinary course of living. So like last year, I ask myself the same questions: “What will lead the economy this year? Will it be the debt-driven consumer or debt-laden corporations? Or will 2003 be the year of “big government?”

The economic and financial risks are high. However, the geopolitical risks are even higher. I can’t think of a year where there are so many wild cards that overhang the market. Too many rogue waves lurk beyond the horizon as storm fronts gather from many directions. Sailors know that rogue waves appear in sets. When one appears, others are sure to follow. The US survived 9-11 by expanding the printing presses at full throttle and going deeper into debt as a country. Since 2001, M3 has grown by $1.5 trillion. It is simply mind-boggling to consider all the permutations and possibilities that exist with so many wild cards hanging over the economy and the markets. With this many what-ifs on the table, it would be by the grace of God and a miracle if none of them are played. I will name the major ones. Any single one of them could throw a forecast way off course. Each one is a major confidence shaker.

• War with Iraq and/or North Korea

• A major terrorist attack that follows a war with Iraq

• A broadening Middle East War

• The fall of the House of Saud

• Sovereign debt defaults, i.e. Brazil

• A spike in energy prices due to terrorism or war

• A major default of a money center bank or major US financial institution i.e. Fannie/Freddie

• The failure of a major derivative player such as a bank or hedge fund

• A spike in credit spreads due to growing bankruptcies

Where Are The Safe Havens?

Given all of these uncertainties, where should one invest this year? I believe the “Next Big Thing” is going to be in “things” such as commodities. The big winners in this decade are going to be gold, silver, and energy. Other commodities from sugar, coffee, cocoa and grains, to other soft goods will also be winners. Commodity prices will rise because of two trends: a declining US dollar and rising populations and industrialization of developing economies.

The time for paper is over and the rise of “things” has just begun. Another trend that is taking place is what Marc Faber calls the reemergence of the emerging economies. Economic power is moving from the West to the East and this trend is irreversible.

What I "See" Ahead in 2003

In summary, economic and financial risks are plentiful this year, but geopolitical risks are even greater. Never can I recall the advent and appearance of so many risks and uncertainties existing at the same time. The age of peace and stability is over. We are now entering an era of war and financial instability. The age of fiat currencies is ending.

As to how this year unfolds, I suspect it will have many twists and turns. The oracles, soothsayers, and fortune tellers will, without doubt, be called upon to make additional divinations as this year progresses or unexpected events take place. In the days of the Greeks, the divinations made by oracles were difficult to interpret. That is because the oracles went into a trance and in this heightened state their answers were difficult to understand. This often necessitated the help of a priestly functionary. The gods spoke directly and only to the oracles. The ancient Greeks and Romans recognized that the gods didn’t answer man's questions clearly, but gave answers that were ambiguous and bewildering. Hence, the need for priestly interpretation since most answers had two meanings. The inquirer never received the medium's utterance directly. They were only allowed to listen. It was usually a lower level functionary or priest's responsibility to convey the official interpretation of the answer. When matters of state were concerned or when a government official, diplomat or a king made an inquiry, answers swayed in favor of the policies of the state. The confused words of the oracle were shaped by the priest to express the official view of government.

I Hope It's Better Than I Expect

Things haven’t changed much in the oracle, soothsayer, and fortune teller business in more than two millenniums. Today the Chairman of the Fed plays the same role as the Oracle of Delphi. Fed vice chairmen and governors play a lesser, but still important role. Analysts, economists, and journalists fill the role of the priests and lesser important functionaries, interpreting the answers given by the oracles. Depending on the state of the economy and the direction of the political winds, it is oftentimes necessary to give ambiguous and double meanings to the utterances of the oracles. Lately, however, they have been crystal clear. “We will do all that is within our power to avoid another 1930’s deflation.”(12) The interpretation of the oracles at the Fed and on Wall Street has been remarkably the same. "Things are better than expected." "The economy is better than expected." "Earnings are better than expected." If a mild winter causes energy prices to soften, then "The weather is better than expected." I suspect the official interpretation to all inquiries made this year will be only three words and three words only: better than expected. The wild cards will be covered in my next Storm Watch Update “Ten Sigma.”  ~ JP

Footnotes

1   "Stargazing: The Art of Forecasting The Financial Future," Storm Watch Update, January 11, 2002.
2   The Richebächer Letter, January 2003, p. 5
3   Bloomberg, "General Motors Profit to Fall as Pension Cost Triples".
4   BusinessWeek, "The Bankruptcy Run Isn't Slowing," January 13, 2003, p. 36-37.
5   BusinessWeek, "When Will Corporate America Pry Open Its Wallet," January 13, 2003, p. 29.
6   Ibid., p. 9.
7   Noland, Doug, "Issues 2003," Credit Bubble Bulletin, http://www.prudentbear.com/, January 3, 2003.
8   Ibid.
9   Correa, Barbara, "Swimming in sea of credit-card debt," http://www.presstelegram.com/, December 28, 2002.
10  Ibid.
11  "Debt Shifts to Consumers From Corporate Coffers," The Wall Street Journal, January 5, 2003.
12  Remarks by Governor Ben S. Bernanke: Deflation-Making Sure "It" Doesn't Happen Here

© 2003 James J. Puplava

Special thanks to Michael Hodges, Grandfather Economic Report, A. Gary Shilling, Insight, and Doug Noland, Credit Bubble Bulletin PrudentBear.

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